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The ‘long’ and ‘short’ of debt funds

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At the current juncture, when interest rates are threatening to move upwards, there is a question among investors — which funds are appropriate and which funds should one exit. Before we discuss the guidance part, let us look at some relevant facts for ease of understanding.

The 16 debt fund categories are defined by SEBI in terms of contours i.e. what a fund in that category is supposed to do. Hence, when you take a decision to invest in a fund, you can take a look at the parameters of that category and get a fair idea.

Debt funds earn their returns from two avenues: accrual and mark-to-market (MTM). Accrual is the coupon or interest that accrues on the bonds and other instruments in the portfolio. Mark-to-market is the valuation done every day, for NAV computation, as per prices prevailing in the market for the instruments in the portfolio. Yield (interest rate) and bond prices move inversely; if yield levels move up, prices come down and the MTM impact is adverse. If interest rates in the market come down, the impact is positive.

When yields or interest rates in the market move up, the instant impact is adverse. However, over a period of time, the accrual level moves up. Fresh money coming into the fund is invested at higher yields and as securities mature, reinvestments happen at a higher yield.

The longer your investment horizon, the better. You have that much more accrual to absorb any MTM loss. Moreover, over a long period of time, market moves in cycles i.e. interest rates move up and come down, and then settle down.

For example, say a debt fund has a portfolio of ₹100 and on a bad day, the adverse MTM impact was ₹1.5. The accrual level of the fund is, say, 6%. If you had invested in the fund just the day before, you would see minus 1.5% in your statement. If you stay invested for three months, your returns would be nil as the fund had accrued ₹6/4 = ₹1.5. Over a holding period of one year, your return is ₹6 minus ₹1.5, i.e. 4.5%.

If you have a horizon of say 10 years, the accrual will be that much stronger and the impact of MTM will be negligible. To be noted, MTM impact can be favourable also, when yield levels are coming down.

Portfolio maturity of a debt fund is the weighted average maturity of all the instruments in the portfolio. The longer the portfolio maturity, the higher is the variability to market movements. In other words, debt funds with longer maturity are more volatile and the MTM impact — both favourable and adverse — are higher. In that sense, shorter maturity funds are defensive.

With this background, now let us come to the guidance on what to do:

Given the view that yields/interest rates are expected to gradually move up over the next year or so, it is advisable to shift from long-maturity debt funds to short-maturity ones. Having said that, if you have an adequately long investment horizon, you can stay invested even in long maturity funds. As mentioned earlier, longer-period accrual and multiple market cycles will even out the interim volatility.

If you cannot digest volatility, then you may gradually move from long maturity funds to short maturity ones. On what is adequate investment horizon, there is no hard-and-fast definition; the ballpark is, if your horizon is more-or-less equal to the portfolio maturity, you are safe. As an example, for a fund with a portfolio maturity of three years, a horizon of three years is adequate and for 10-year maturity fund, a horizon of 10 years is desirable.

Check the portfolio quality also. If your horizon is say three years and longer, for availing of tax efficiency, there are funds in the categories of banking and PSU, corporate bond, short duration, etc. The fact sheet of the fund you intend to invest in, is available on the website of the AMC. All the details of portfolio maturity, portfolio composition, etc. is available on the fund fact sheet.

From the credit risk perspective, government security funds are the best. However, these funds have relatively longer portfolio maturity and are more volatile. Hence a long investment horizon is imperative for G-Sec funds.

For deployment of fresh money, which does not have the benefit of accrual as in the case of funds you had already invested in, think through the horizon you have and whether you like the initial volatility that may happen, in case yields move up and MTM is adverse. For existing investments, if it is in long maturity funds and you want to stay put for three years for tax efficiency and you are nearing three years, you can stay put.

The up-move in yields is expected to be gradual and calibrated. If you have completed three years and your corpus is already tax efficient, it is a matter of remaining horizon. If the remaining investment period is say six months or one year, you may shift to a shorter maturity one. If your remaining period is few more years, then you may stay put.

There is a common belief that in a rising interest rate scenario, Floating Rate funds are advisable as it would benefit from rising interest rates. However, it is not a one-to-one correspondence. The explanation is technical; to put it simply, real floating rate bonds, where the coupon rate is benchmarked to say MIBOR (which moves along with RBI defined rates) are rare. These fund portfolios are constructed as “synthetic floaters”.

Conclusion

If you are working with an advisor or distributor, you can take guidance. If you are DIY, you may do a review of your debt fund portfolio as per the parameters discussed above. To be noted, the expected up-move in yields over the next one year or so would be gradual and you have the time to execute any changes.

(The writer is a corporate trainer (debt markets) and author)

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Printable version | Apr 23, 2021 10:30:31 PM | https://www.thehindu.com/business/Industry/the-long-and-short-of-debt-funds/article34008255.ece

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